One of the key strategies for managing tax burden in retirement is selecting between a Traditional IRA and a Roth IRA. Understanding the features of each, as well as the tax benefits and RMD (Required Minimum Distributions) rules, is important for making the right choice.
1. Traditional IRA
A Traditional IRA is a tax-deferred account where you get tax benefits when you contribute, and you pay taxes when you withdraw in retirement. However, this account is subject to RMD rules, meaning you must start withdrawing a certain amount starting at age 72. The amount you withdraw is considered income and is taxed accordingly.
2. Roth IRA
A Roth IRA allows you to pay taxes upfront when you contribute, and then withdraw the funds tax-free in retirement. The Roth IRA does not have RMD rules, meaning you are not required to withdraw funds at any age. This makes it a favorable option for long-term tax savings.
3. RMD Calculation: Forced Withdrawals Starting at Age 72
With a Traditional IRA, RMD (Required Minimum Distribution) rules apply starting at age 72. The RMD amount is calculated by dividing the account balance by the distribution factor provided in the IRS life expectancy table.
Example: RMD Calculation for a $700,000 Traditional IRA at Age 72
- Account Balance: $700,000
- Distribution Factor at Age 72: 27.4 (IRS life expectancy table)
RMD Calculation:
RMD = $700,000 ÷ 27.4 ≈ $25,537.93
So, at age 72, the RMD from a $700,000 account would be approximately $25,538.
4. Standard Deduction and Tax Calculation
The Standard Deduction for 2025 is approximately $27,000 for married couples filing jointly. This amount is tax-free, meaning if your RMD amount is within this limit, no tax is due.
Example: If the RMD is Within the Standard Deduction
- RMD Amount: $25,538 (at age 72)
- Standard Deduction: $27,000
Since $25,538 is within the Standard Deduction, no tax will be due on this amount. In other words, if the RMD is within the Standard Deduction, no tax will be imposed, meaning there is no tax burden.
Example: If the RMD Exceeds the Standard Deduction
- RMD Amount: $35,000
- Standard Deduction: $27,000
In this case, $27,000 would be tax-free, but the remaining $8,000 would be taxed. This amount is considered income and will be taxed at the appropriate tax rate.
Conclusion
When your tax-deferred account balance is below $700,000, a Traditional IRA is often the better choice. You can benefit from the tax-deferred growth while still using the Standard Deduction to avoid taxes on your RMD amount. Since the RMD is likely to remain below the Standard Deduction, it allows you to minimize taxes in retirement.
However, if your account balance exceeds $700,000, you might want to consider transitioning to a Roth IRA to avoid the impact of RMDs and continue to grow your funds tax-free without forced withdrawals.
By properly utilizing a Traditional IRA and a Roth IRA, you can minimize tax burdens and avoid RMDs, setting up a more efficient retirement strategy.
